Presented By: Mohammad Atif Nahush Upadhyay Neha Jindal Pallavi Agarwala

Enron was on of the worlds leading energy, commodities, and services co. Formed in July 1985, with the merger of Houston Natural Gas and Inter North of Omaha, Nebraska. It became the 7th largest company in the Fortune-500 list in less than 15 years of its operation.

Kenneth Lay, Chairman, Enron Mr. Jeffrey Skilling, former CEO, Enron Mr. Andrew Fastow, CFO, Enron Arthur Anderson, Enron Audit firm

Creation of off balance sheet entitiesSPVs/SPEs Mark-to-Market accounting Inflating asset values Tax evasion (Cookie Jar Accounting) Fake revenues Insider trading

What are SPEs/SPVs? Special Purpose Entities is a legal entity created to fulfill narrow, specific or temporary objectives. SPE's are typically used by companies to isolate the firm from financial risk. A company will transfer assets to the SPE for management or use the SPE to finance a large project thereby achieving a narrow set of goals without putting the entire firm at risk.

Enron used EITF (Emerging Issues Task Force) resolution 90-15, created in 1990, which allowed corporations to not report partnerships financial conditions in its own financial statements if outsiders contributed even 3% of the capital (the other 97% could come from the company.)

Enrons creation of over 3000 partnerships started around 1993 when it teamed with CALPERS(Calif. Public Retirement System to create JEDI(Joint Energy Development Investments)

Next Enron entered into partnership with Chewco (another SPE under Enron) which would purchase CALPERS share in JEDI
To pay off CALPERS, Chewco took Loan from Barclays bank (guaranteed by ENRON) Credit from JEDI(whose only asset was Enron stock Enron effectively became the sole partner in JEDI and yet avoided its inclusion in its books

Enron was diversifying and spreading itself in various industries. Enron entered the derivatives market. Enrons subsidiary invested in a start up telecommunication company Rhythms NetConnections. It invested $10 millions. Per share costing $70. Due to internet boom Enrons stake climbed hundreds of millions.

Enron now entered into a series of transactions with a SPE called Raptor(owned by another Enron SPE LJM1).

Enron exchanged shares in technology companies for a loan, which Raptor funded by issuing its own securities to investors It committed to Raptor to provide its own stock if Raptors asset value decreased. It promised to maintain them at $1.2 billion.

This derivative carried the risk of diluting the ownership of Enrons shareholders. Investors in Raptor were essentially buying Enrons debt. The performance of Rhythms NetConnection was irrelevant to them. The dot com bubble burst made the shares of Rhythms NetConnection worthless. Enron did not reflect these declines in its quarterly financial statements.

Enrons core business was losing moneyshifted its focus from bricks-and-mortar energy business to trading of derivatives. In 1999, Enron launched EnronOnline, an Internet-based trading operation, which was used by virtually every energy company in the United States Enron adopted mark to market accounting, in which anticipated future profits from any deal were tabulated as if real today. Thus, Enron could record gains from what over time might turn out losses.

The derivatives were used to inflate the value of certain assets it held by selling a small portion of those assets to a SPE at an inflated price and then revaluating the lions share it held at the inflated price.
They did this by selling derivatives associated with the rights to transmit over dark fiber.

It is very difficult to value this. Enron became the sole entity decide the value. This increased the asset value without any inflow of revenues.

In practice Enron recorded derivative transactions as assets from price risk management and liability from price risk management. Further inflating asset values and avoiding tax by increasing liabilities.

Gains depending on many assumptions about interest rate, customers, costs and prices provides opportunities for management to create and manage earnings Enron recognized revenue at the time contracts (even private) were signed based on net present value of all future estimated revenues and costs.

Cookie Jar Accounting: The corporate accounting practice of taking a reserve to reduce profits in good years and then using that reserve to increase profits in bad years.
Enron avoided hundreds of millions of dollars in taxes by its use of stock options. Corporate executives received large quantities of stock options. When they exercised these options, the company claimed compensation expense on their tax returns. Accounting rules let them omit that same expense from the earnings statement. The options only needed to be disclosed in a footnote.

Enron sold parts of its inventory and derivatives to its own SPEs/SPVs and recorded them as sales.
In return to these it accepted parts in cash and parts through notes receivables.

To fund these notes recievables the SPEs issued securities(again backed by Enrons assurance) Example the case of fiber optic cables sold to LJM1

Chief Financial Officer Andrew Fastow led the team which created the off-books companies, and manipulated the deals to provide himself, his family, and his friends with hundreds of millions of dollars in guaranteed revenue, at the expense of the corporation for which he worked and its stockholders.

Enron enjoyed high credit rating. The derivative traders faced intense pressure to meet quarterly earnings target imposed by management and security analysts. Traders manipulated the reporting of their real economic profits and losses in an attempt to fit the imagined accounting profits that drove the Enron management.

Nov. 8, 2001: Enron says it overstated earnings dating back to 1997 by almost $600 million Nov. 9, 2001: Enron agrees to a deal in which smaller rival Dynegy Inc. will buy Enron for some $9 billion in stock. As part of the deal Chevron Texaco agrees to inject $1.5 billion in fresh capital immediately.

Nov. 28, 2001: Major credit rating agencies downgrade Enrons bonds to junk status. Dynegy terminates its agreement to buy Enron. Dec. 2, 2001 Default: Enron files for bankruptcy

The steady decline in the Total asset turnover ratio and in the return on assets ratio(DU PONT Analysis)
The high difference between operating profits from the cash flow statement and net profit or loss from income statement.

Arthur Anderson(Enrons auditor) failed to discover the derivative transactions.

Enron also failed to follow the accounting rules. The accountants and auditors, who were being paid by Enron, failed to accurately state the position of the company and let these technicalities pass.

Current laws and SEC regulations allow firms like Andersen to provided consulting services to a company and then turn around and provide the audited report about the financial results of these consulting activities. Ability for private companies like Enron to hire and pay its own auditors. Our legal system also allows companies like Enron to manage their own employee pension funds. A no. of documents were shredded and destroyed and important files deleted by Anderson. Anderson provided both external and internal audits Anderson was paid $52 million in 2000, the majority for non-audit related consulting services.

Enron paid several hundred million in fees, including fees for derivatives transactions. None of these firms alerted investors about derivatives problems at Enron.
In October, 2001, 16 of 17 security analysts covering Enron still rated it a strong buy or buy.

The accounting misstatements were discovered starting when on November 8th of 2001 Enron told investors they were restating earnings for the past 4 and years. Declaring bankruptcy shortly after restating its earnings was also a clue. Sherron Watkins, a vice president at the time, wrote a memo to chairman Kenneth Lay about the fraud that was occurring.

Enron filed for bankruptcy on December 2, 2001.

$00.26 (Dec,2001) Jan. 25, 2002: John Clifford Baxter, former Enron vice-president, is found dead in his car. He was shot once in the head, and authorities treat his death as a suicide. Baxter resigned as vice-president in May 2001.

Share Price : $90.56 (Aug 2000)

Feb. 4, 2002: Mr. Lay resigns as Chairman July 5, 2006: Ken Lay, 64, dies of a heart attack Sept. 26, 2006: Andrew Fastow, Enron's former chief financial officer, is sentenced to six years in prison. Oct. 23, 2006:Former Enron chief executive officer Jeffrey Skilling is sentenced to 24 years, four months in jail for his role in the collapse.

Enron sold its last business, Prisma Energy, in 2006, leaving it as an asset-less shell. In early 2007, it changed its name to Enron Creditors Recovery Corporation. Its goal is to pay off the old Enron's remaining creditors and wind up Enron's affairs. Enron's new board of directors sued 11 financial institutions for helping Lay, Fastow, Skilling and others hide Enron's true financial condition. The proceedings were dubbed the megaclaims litigation. Enron was able to obtain nearly $20 million dollars to distribute to its creditors as a result of this litigation

U.S. legislative response to recent spate of accounting scandals (Enron, WorldCom, Global Crossing, Adelphia Communications) Compliance with comprehensive reform of accounting procedures is now required for publicly held companies, to promote and improve the quality and transparency of financial reporting by internal and external auditors.

Companies must list and track performance of their material risks and associated control procedures. CEOs are required to vouch for the financial statements of their companies. Boards of Directors must have Audit Committees whose members are independent of company senior management. Companies can no longer make loans to company directors.

SOX Act Essentially a response to one cause of the financial irregularities: failure by auditors, SEC, and other agencies to provide adequate oversight. Not clear how SOX Act will prevent misuse of off balance-sheet activities that are difficult to trace.
Sox Act also does not address other key causes:

misaligned incentives (e.g., shift from cash to

stock option compensation)

focus on short-run profits rather than long run profit performance.